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Do Pass-Throughs Really Need a Bigger Tax Break?

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By Michael Rainey

November 28, 2017

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One of the issues threatening to delay or even derail the GOP tax bill is the uneven treatment of corporations and pass-through businesses. Republican Sens. Ron Johnson of Wisconsin and Steve Daines of Montana, the only senators who have declared they can’t vote for the bill in its current form, are pushing for a bigger tax cut for pass-throughs, and say their support hinges upon finding a satisfactory solution. Johnson, a member of the Senate Budget Committee, said he voted to send the tax bill to the Senate floor Tuesday based on progress being made toward that solution. “I’m getting commitments we are going to get this fixed,” he said.

What’s the issue? The Senate tax bill cuts the corporate tax rate from 35 percent to 20 percent, but creates a different set of rules for pass-throughs. As the name implies, pass-through businesses pass income on to their owners, who then pay taxes at the individual rate. The Senate bill lowers the top individual rate to 38.5 percent and provides a 17.4 percent tax deduction for pass-through income, creating an effective top rate of 32 percent for the owners of pass-through businesses.

Why is that a problem? Simply put, Johnson and Daines say that the 17.4 percent deduction isn’t big enough, and the resulting effective tax rate is too high. They’re reportedly negotiating to raise the deduction to at least 20 percent. Daines is framing the issue in terms of the competitiveness of local small businesses — "I want to see changes made to the tax cut bill that ensure Main Street businesses are not put at a competitive disadvantage against large corporations,” he says —and Johnson, whose family owns a multi-million-dollar manufacturing business that provides pass-through income, has said he has similar concerns. However, the liberal Center on Budget and Policy Priorities says this claim is misleading, since corporate income is taxed twice, with the shareholders and employees paying individual income tax on dividends and wages. If the tax rate for pass-throughs were the same as the corporate rate, the net result would be much lower rates for pass-through owners, since they would pay taxes only once.

Is this really about mom-and-pop businesses? Most small businesses pay well below 32 percent already, since the pass-through income they provide falls below the top income bracket. The Center on Budget and Policy Priorities says that “86 percent of filers with pass-through income are currently taxed at a statutory marginal income tax rate of 25 percent or less.” At the same time, the majority of income that flows through these businesses is claimed by a small number of high-income taxpayers. According to the Brookings Institution, 70 percent of the income that flows through these businesses – think law firms or hedge funds or family-owned factories — goes to the wealthiest 1 percent of taxpayers.

Who is opposed to reducing the pass-through rate? One of the basic challenges here is simple math: Giving pass-throughs a bigger tax cut could get very expensive — and that risks losing support from the handful of fiscal hawks in the Senate (Bob Corker, Jeff Flake, James Lankford, John McCain, Jerry Moran) who say they are worried about adding even more to the debt. Axios puts it this way: “Johnson and Corker sit on opposite ends of a Catch 22 seesaw: Johnson wants lots more money for ‘pass-through’ businesses. But every extra dollar you give him is another dollar that will blow out the deficit and worry deficit hawks like Corker, Flake and McCain.”

Could this kill the GOP tax bill? While Sens. Johnson and Daines say they won’t vote for the bill unless they get lower pass-through rates, it looks like there’s room to make a deal. One bargaining chip that could come into play involves the corporate deduction for state and local tax payments. Eliminating the deduction from the Senate bill would generate $100 billion or more, according to Daines, and those savings could be used to lower the pass-through rate further. “We’re gonna make them happy,” said Finance Committee Chairman Orrin Hatch. “But we’re not sure we can do exactly what they want to have done.”